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Should We Ride the New Economy Wave

Pascal Blackburne & Luc Synaeghel2018-09-07

The current outperformance of US equity indices goes beyond an investor craze for Facebook, Apple, Amazon, Netflix and Google (collectively known as the FAANG stocks). It reflects a new versus old economy battle, which is starting to have serious real-world implications. And this battle is being fought on uneven terms, with still cheap and plentiful money providing an undue advantage to new economy companies.

With every analyst currently rating the FAANG stocks “buy”, it is no wonder that the heavily new economy-weighted Nasdaq is outperforming other US equity indices – and indeed that the US is surpassing other markets across the globe. While we do not dispute the impact that e-commerce and social media are having on just about everybody’s daily life, we do question the sustainability and the valuation of new economy business models.

A number of countries have laws that prohibit businesses from selling at a loss. E-commerce companies have been able to circumvent such laws, not only because they still escape local jurisdiction but also largely thanks to a long-flowing stream of almost “free” money. Just consider that most e-commerce companies are still seriously loss-making, even after several years of doing business in some cases. Investors and banks would certainly not have been that patient with traditional brick-and-mortar retailers!

What if (or, should we say, when) monetary conditions tighten markedly? At the world central bankers’ recent retreat in Jackson Hole, Fed Chairman Powell asserted his independence both from Donald “Twitter” and from the traditional economic models used to predict growth and inflation. In short, he intends to push the Fed funds rate up to the level currently considered as neutral (2.9%) and then shift to a wait-and-see, dubbed “risk management”, approach.

Wage inflation is clearly softer than could have been anticipated given the tight employment situation in the US, but still it is creeping up – having now reached 2.9%. If the Trump administration pushes forward with its plan to put more people to work in the Rust Belt, all the while keeping the borders closed, the US labour market could actually move into shortage.

As we have repeatedly voiced in previous letters, we would not be surprised to see US inflation move substantially higher – forcing the Fed to hike rates faster than expected. The whammy on new economy companies would be double: their sky-high valuations would deflate, and their cheap money-based business models no longer function. Worse, these two phenomena would feed on each other on the downside, just as they have been doing on the upside.

For consumers, this would mean a sudden return to the old world, where goods are sold for a profit and not shipped for free. But, even absent a financial market correction, that shift is bound to occur at some point. If the new economy wave is allowed to roll on for several more years, casualties will mount in the old economy and monopolistic/oligopolistic situations ensue. Leading e-companies will then be able to impose price increases... as, incidentally, Netflix just did.

A stormy summer for emerging market currencies

Source Bloomberg

The Argentina Peso came under tremendous pressure in August, losing nearly one third of its value versus the US dollar. On a six-month basis, it has virtually halved. The Turkish lira followed a similar downward path, shedding 26% in August and 42% over the past six months.

Note that Argentina and Turkey are not the only two emerging countries with a twin (budget and current account) deficit and high foreign currency debt, generally seen as the causes for their sharp currency correction. (We understand “high” foreign currency debt as debt that is not sufficiently covered by foreign currency reserves). At the very least, South Africa, Indonesia and Pakistan are in a comparable position. Other countries could also find themselves in a similarly dangerous situation sooner or later if they do not address their twin deficits and/or foreign currency debt: Brazil, India, Malaysia, Ukraine, Poland and, to a lesser extent, Mexico, Columbia and Chile.

What all these countries have in common is their dependence on external financing, making them extremely vulnerable to a shutdown of the easy money tap. As such, the sudden blowups of the peso and lira could be an indication of what lies ahead for new economy companies that generate no free cash flow, when financing becomes more difficult.

In this end of cycle environment, with the Nasdaq Composite index trading at over 50x 2018 projected earnings, there is simply no risk premium for investors to fall back on. A change in financial conditions could send financial markets spiraling down – with the loss in trust compounding the correction.

Timing the turning point is of course impossible. In the meantime, as portfolio managers we are left with a conundrum: as much as we would like to participate in the FAANG rally, we are reluctant to pay the steep prices at which these stocks are currently trading.

Gold also under pressure

Source Bloomberg

The more President Trump pressures (or even sanctions) countries like China, Iran, Turkey and Russia, some of them historical US allies, and neglects international forums such as the United Nations or World Trade Organisation, the more investors could be expected to run to goldas a safe haven. Or so we thought – but what did we miss?

Digging into gold fundamentals reveals that second quarter 2018 supply amounted to ca. 1,120 tonnes, of which 835 tonnes came from mining and the rest from recycling. Demand was on the low side at 964 tonnes, leaving the market oversupplied and pushing the price down.

Demand for jewellery (about half of aggregate demand), for bars and coins (ca. 25%) and for technology (just shy of 10%) tends to be pretty stable over time. While generally highly unpredictable, central bank demand has also proved quite steady over the past couple of years. At the margin then, and despite the fact that it accounts for only ca. 5% of aggregate demand, investor ETF demand has been driving the gold price, alongside hedge and commodity funds (that mainly trade futures – so-called “paper gold” – and speculate on the basis of technical analysis).

The fact that US investors sold gold ETFs over the last few months, and that the aforementioned funds made record sales of futures following gold’s several failed attempts to breach the USD 1,350/ounce level during the January to April period, sent its price reeling.

Several explanations have been put forward as to why US investors disposed of (part of) their gold ETF holdings, notably rising interest rates that make Treasuries more attractive. Most likely, investors simply got scared when the gold price started to correct on heavy technical-based short selling and then followed the herd.

There is, however, a hard floor to the gold price: its production cost, which lies in the USD 850-1,050/ounce range for the larger mines. Were such levels to be approached, these mines would cut production. At ca. USD 1,200/ounce, gold remains well above that floor. Over the past five years, the closest it got to it was USD 1,050 at the end of November 2015. We thus think it fair to say that gold’s downside from current levels is rather limited – with substantial upward potential if/when the situation really gets out of hand. A short-term move back up towards USD 1,350 might even not be excluded if the “hedgies” become convinced that the price has stopped falling and begin to reverse their short positions.

As for gold mines, their stock prices generally follow gold but with a high beta. This higher sensitivity is readily understandable. When gold was trading at USD 1,350 (as it was in April) and assuming a production cost of USD 950, mining companies generated a gross margin of USD 400/ounce produced. With the gold price now around USD 1,200, their gross margin has dropped to USD 250/ounce, a cut of almost 40%. It is thus quite normal for gold mine stocks to have corrected much more than the price of gold itself. The reverse should of course be true if gold finds its way back up.

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